Boost your decision-making with these three economic concepts

Find out how a better understanding of economics, and three key concepts, can help improve your decision-making skills.

Can an understanding of economics help improve our decision-making skills? Absolutely. After all, as Tim Harford put it in Undercover Economist, economics is the study of why people make the decisions they make.

Here are three key economic concepts that will make you a more informed decision-maker:

1. Opportunity cost

Opportunity cost refers to the fact that by making one decision, we close off alternative ones.

This concept is easily described in the context of financial decision-making: buying something for £20 means that you cannot spend that same £20 again - you have lost the opportunity to do so.

But, opportunity cost is easily applicable to non-financial situations as well - there can also be costs to our time, personal development or health. For example, deciding whether or not to go to university is associated with opportunity costs because the three years it takes to get a degree could be spent on gaining professional experience.

Opportunity cost is closely linked to the “sunk cost fallacy”. “Sunk costs” refer to resources, financial or otherwise, that we have already incurred and which cannot be recovered. The fallacy, or “misconception”, is that if we have spent resources (whether time, money or something else) on a particular project, we should continue to do so, even if the project is no longer worthwhile or likely to succeed, because not doing so would waste the resources that we have already spent.

This is illogical because (a) the costs incurred are “sunk” and cannot be recovered anyway, so whether they have been wasted is irrelevant and (b) it ignores opportunity cost—those resources could be better used elsewhere!

2. Supply and demand

Supply and demand is the concept that a product’s price depends on the number of consumers that want it (demand) and its availability (supply). Prices increase when the demand for a product or service is greater than its supply and fall when supply exceeds demand.

Typically, a cheaper product will be in higher demand because it is more universally affordable. As such, producers may make more of it, thereby increasing the supply, in order to meet consumer demand.

On the other hand, companies sometimes deliberately restrict supply in order to maximise the price as consumer demand will far exceed the availability of the item: the Starbucks unicorn frappe is a great example - available for just a few days, it had consumers flooding the stores.

So, how can understanding supply and demand improve decision-making? Well, supply and demand is in fact a useful tool for identifying opportunities in both our personal and professional lives. For example, careers that are in high demand (e.g. finance, software engineering) often offer higher wages. Supply and demand also explains why areas that have a lower demand for housing tend to be more affordable.

3. Incentives

Incentives drive our decision-making and behaviours. As humans, we are hard-wired to respond positively to things that will generate a positive reward and reject those things that come at a high cost.

Whenever we enter into a transaction, we usually perceive that what we have gained is at least as valuable as what we have lost, or parted with - when this is not the case, we feel ripped off.

One reason why Netflix is so popular is because subscribers believe that the £12/month subscription cost provides them with more value than what £12 would otherwise get them—this low price creates a powerful incentive to subscribe.

Unsurprisingly, companies and governments recognise that people respond predictably to incentives. For example, many governments around the world offer grants to people that purchase electric vehicles, which are typically quite expensive, in order to encourage climate-friendly consumer behaviour.

 

Although we ultimately make decisions depending on our individual goals and aspirations, these three economic concepts can go a long way towards a more informed decision-making.